FIAP International portfolio diversification for pension funds Marlies

FIAP International portfolio diversification for pension funds Marlies van Boom AEGON Asset Management Head of Investment Solutions May 2009

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Outline International diversification Literature Example Life Cycle Investing Looking Forward 3

Literature International Diversification improves risk-return profile Markowitz (1959) Solnik (1974) Sercu (1980) Adler and Dumas (1983) But, most literature focusses on developed equity markets. Does this also hold for an emerging market investor? 4

Emerging Markets point of view Facts from research: All investors tend to have a home bias French and Poterba (1991), Kho, Stulz and Warnock (2006) Emerging markets are less integrated with developed markets Bekaert & Harvey (1995) Higher expected returns in emerging markets De. Roon, De Goeij and Pungulescu (2009) ? Does an EM-investor still benefit from diversification? 5

Example Let’s take the view of a investor of emerging Europe (e. g. Poland) with a defined contribution pension plan. He can choose to invest in: Emerging Europe bonds and equities (2 assets) Both Emerging, European and World bonds and equities (6 assets) The table below shows the characteristics: All investment are measured in Polish Zloty, based on the sample period of January 1995 - December 2006 EM bonds is US-dollar denominated debt. 6

Mean Variance The efficient frontier significantly moves to the left Diversification doesn’t increase returns, but lowers risk 7

Mean Variance What is the effect of lower risk? Let’s compare to equal return portfolio’s: A: 55% Em. Equities and 45% Em. Bonds B: globally diversified portfolio B A 8

Wealth Accumulation World basket has same expected result Smaller bandwidths => risk reduction of 35% Using optimal portfolio’s characteristics and an inflow of 1000 PLZ per annum, net of fees 9

Outline International diversification Literature Practical Example Life Cycle Investing Looking Forward 10

Life Cycle Investing Defined Contribution Pension The investor would like to change his investment style Maturity > 20 years: maximum return Maturity 10 -20 years: risk-return in balance Maturity < 10 years: a low risk profile However, Within emerging markets an investor cannot lower his risk profile, so one should invest in other markets as well. 11

Life Cycle Over time switch to less risky portfolio (1 ->2 ->3) 1 2 3 12

Life Cycle & Diversification Smaller bandwidths at the end of the spectrum Risk reduction of 15% at end date 13

Life Cycle- Final Years Fixed end date nears: Focus on risk reduction Risk reduction of 50% 14

2008 Credit Crisis “Diversification did not work at all during the crisis” This is not entirely true. Every risk asset sold off during crisis But… developed market bonds are a safe haven Emerging market currencies dampen the blow Even crises don’t change our results! NB. Similar results hold for other Emerging Markets and other crises. 15

Outline International diversification Literature Practical Example Life Cycle Investing Looking forward 16

Looking Forward Data Our example is based on a relatively short sample period, as reliable EM-data is not available Low bond yields Emerging market bonds had the best performance in our example. However, bond yields are much lower nowadays, leading to lower expected returns. Globalization Emerging markets have been less integrated with developed markets, but this changes over time. All important, but don’t change our conclusions! 17

Conclusions Emerging markets (equity and bonds) Delivered high returns But with a very high volatility (credit crisis) International diversification is essential Leads to a lower risk profile Especially convenient for DC-pension plans Looking forward Data, globalization and low bond yield play a role Even strengthen need to diversify! 18

Diversification rules! AEGON Asset Management – Investment Solutions - Marlies van Boom 19